While India is the ninth-largest national airline market in the world, it ought to be much larger, and both industry executives and aviation officials know it.

“Aviation [is] a vital tool that could be used to fuel economic growth,” a Civil Aviation Ministry official acknowledges. He says the ministry is seeking to increase outlays in the federal budget to develop the aviation infrastructure in smaller cities and stabilize the debt-ridden national carrier, Air India.

It is one sign that India is making a concerted effort to remove at least some of the obstacles to growth of its airline industry. Estimates suggest that domestic traffic in India will reach 160-180 million passengers annually in the next 10 years and international traffic will exceed 80 million passengers per year, up from the current 60 million domestic and 40 million international passengers.

According to the International Air Transport Association’s (IATA) forecast for 2012-16, India’s domestic air travel market should be among the top five globally, experiencing the second-highest growth rate over that period. But it will not happen automatically.

“Building the future for a successful aviation sector must begin with solving the well-cataloged problems of airlines in India today,” says Tony Tyler, director general and CEO of IATA.

“The sector is growing, but not profitably. Airline losses approached $2 billion in the year ended March 2012, after losing $3.5 billion over the previous three years,” Tyler says. “With some relief in oil prices and capacity rationalization, the red ink may recede slightly. But the crisis continues. All the network carriers are struggling financially.” State-run Air India is on life support and private carrier Kingfisher Airlines is on the brink of death.

A lot has changed in the past decade, mainly with the rise of low-cost carriers (LCC). From almost nothing in 2003-04, the domestic market share of LCCs, including the low-cost arms of full-service carriers, today exceeds 70%. And the LCCs believe they have just begun to develop a huge potential market.

But first, there is need for airports that will complement the no-frills model. As one airline official says, “There is great scope for a new dimension for India civil aviation in connecting to Tier 2 and Tier 3 cities [because of] rapid urbanization of the country and the emergence of several smaller towns as industry and business centers.”

The government agrees that the future of Indian aviation is in smaller cities. Ajit Singh, the minister of civil aviation, says the development of low-cost airports is the most important component of the ministry’s effort to improve connectivity across India.

The government has engaged Deloitte as a consultant to identify the factors inhibiting the growth of domestic connectivity and suggest steps to correct them. That will likely include enhancement of helicopter operations and construction of heliports to serve less populated areas, including religious and tourist sites.

The Civil Aviation Ministry’s Vision 2020 plan emphasizes development of the country’s infrastructure and aims for user-friendly airports to handle as many as 280 million passengers per year by 2020.

“One of the key challenges will be to ensure that Indian airports function with the same efficiency as international hubs,” says one airline official.

Buoyed by the success of the public-private partnership (PPP) model in airport development, the government plans to invest $30 billion in the next 10 years and modernize more existing airports.

Airports in New Delhi, Mumbai, Bengaluru (formerly Bangalore), Hyderabad and Cochin are being placed in PPPs now. A new terminal is under construction at Mumbai airport, with international operations set to begin by August and a second phase, for domestic operations, to be ready by August 2014. The existing greenfield airport at Bengaluru is undergoing expansion to meet the growing capacity demand.

The Airports Authority of India has undertaken expansion and upgrading of airports at Kolkata and Chennai. And the government has approved 15 more airports under the Greenfield Airports Policy, most of which are being developed in PPPs, the ministry official details.

However, skeptics question the authority’s abilities to manage infrastructure growth. They say that of the 115 airports run by the authority, only 71 are commercially operational. The rest are closed, mainly because they have proved to be economically unviable.

The ministry official cites examples of companies such as Regional Airport-Holdings International Ltd. (RAHI), which has revealed plans to develop India’s regional aviation market, starting with two airport projects. Over the next five years, RAHI has plans to invest $700 million in more than 15 aviation infrastructure and services projects.

In addition to the model agreement to develop greenfield airports under the PPP model, the government has also allowed 100% foreign direct investment, under the automatic route.

“The PPP model for developing greenfield airports as well as upgrading existing airports has provided the opportunity to develop integrated airport cities on the lines of Dubai and Hong Kong,” says Promananda Elangbam, marketing manager at Bangalore International Airport Ltd.

Meanwhile, although there is an unprecedented increase in traffic and demand, almost all Indian carriers are in the red. Operating costs are daunting, propelled by high fuel costs and taxes, and debts are soaring.

The government, for its part, opened up foreign direct investment (FDI) in Indian carriers to airlines abroad and is allowing direct importation of aviation fuel.

“Permitting FDI by foreign airlines was a right step for Indian aviation, as it requires resources for expansion to connect Tier 2 and 3 cities with metros and foreign destinations,” says R. Neelakantan, chief financial officer of no-frills airline SpiceJet.

Clearly, the air travel market in India has room for expansion. India is estimated to have one aircraft for every 2.89 million people, which is minuscule in comparison to one for every 1.14 million in China, 0.96 million in Indonesia, 0.89 million in the Philippines and 0.63 million in Brazil.

Boeing estimates that Indian carriers will require 1,450 new aircraft worth $175 billion to cope with increasing passenger traffic over the next 20 years.

Despite such forecasts and India’s attempts to foster its aviation sector, some policies threaten to nip growth in the bud.

Fuel constitutes 40-50% of Indian airlines’ operating expenses. A major contributor to the high fuel prices is the 4-30% value-added tax levied by various state governments. Efforts are under way to persuade Indian state governments to reduce their taxes. Carriers also complain about India’s service taxes on air tickets and landing and navigation fees.

IATA’s Tyler says the fundamental problem is that India has a fragmentary approach to aviation policy that does not connect the dots in the value chain. “A coordinated ‘India Inc.’ approach that addresses the central challenges of infrastructure, costs, and taxes is urgently required,” Tyler says.

If India can establish a coherent aviation policy, the sector’s advocates point out, the economic and social benefits that derive from improved competitiveness and air connectivity would be enormous. The aviation industry accounts for close to 0.5% of Indian gross domestic product and 1.7 million high-productivity jobs. IATA estimates that the value added by each employee in air transport services in India is approximately 10 times higher than the Indian average.